What is accounting rate of return (ARR)?
Accounting rate of return is a capital-budgeting metric that measures average annual accounting profit as a percentage of an investment base. It answers the question: how much profit does this project generate per dollar of investment, expressed as a percentage?
ARR is widely used for quick project screening because it is simple, uses data already available in profit forecasts, and produces a percentage that is easy to compare against a company's hurdle rate. Its main limitation is that it ignores the time value of money — profit earned in year one is treated the same as profit earned in year five.
Two formula variants — which one to use
There are two common versions of the ARR formula. The difference is in the denominator — what you treat as the investment base. Both are valid; consistency within a comparison is what matters.
Variant 1 — Initial investment
Simpler and more conservative — divides by the full upfront cost. Common in introductory finance courses and some internal screening frameworks.
Variant 2 — Average investment (most common in capital budgeting)
More accurate because it recognises that the book value of the asset declines over its useful life. As the asset depreciates, the investment base shrinks, so the denominator is the average across the full life — not the peak at the start. This produces a higher ARR than Variant 1 on the same numbers.
Here is the same project calculated both ways — $120K investment, $20K salvage, $18K average annual profit:
Same project, same profit — but ARR of 15% vs 25.7% depending on which variant you use. This is why specifying the method before comparing projects is essential.
Where depreciation fits in
ARR uses accounting profit after depreciation, not cash flow. Straight-line depreciation reduces the annual profit figure before it enters the ARR formula. You need to subtract depreciation from revenue or cash inflows to arrive at accounting profit.
Here is the full calculation walkthrough for the $120K equipment example:
If you are given revenue and cash inflows rather than accounting profit, you need to subtract annual depreciation first: Accounting profit = Annual revenue − Annual costs − Depreciation.
Step-by-step method
(Initial − Salvage) ÷ Useful life. This is the annual
charge that reduces book value each year.
Initial investment or
(Initial + Salvage) ÷ 2 (average investment).
Check your textbook, exam spec, or company policy.
(Average annual profit ÷ Investment base) × 100
Worked examples
Basic ARR — no salvage
Cost: $50K · Total profit over 5 yr: $20K · No salvage
📊 ARR = 8% (initial method)
With salvage value
Cost: $100K · Salvage: $20K · Avg profit: $12K/yr
✅ ARR = 20% (average method)
Machine A vs Machine B
A: $70K cost, $9,100/yr profit · B: $90K cost, $10,800/yr profit
✅ Machine A wins despite lower $ profit
Pass/fail vs 14% target
Cost: $60K · Avg profit: $9,600/yr · Required ARR: 14%
✅ Passes — proceed to cash flow analysis
ARR vs NPV vs Payback — when to use each
ARR is one of several capital-budgeting tools. Understanding where it fits in the toolkit prevents over-reliance on its simplicity:
| Method | Based on | Time value? | Best for |
|---|---|---|---|
| ARR | Accounting profit | No | Quick screening, exam problems, accounting-focused decisions |
| Payback period | Cash flow | No | Liquidity risk — how fast you recover the investment |
| NPV | Discounted cash flow | Yes | Primary decision metric — accounts for timing and risk |
| IRR | Discounted cash flow | Yes | Comparing projects of different sizes — percentage return metric |
In practice, ARR acts as the first filter — if a project fails on ARR, it is unlikely to pass on NPV. If it passes ARR, you move to discounted cash flow methods before final approval. Using ARR instead of NPV for major decisions is a common mistake.
Common mistakes to avoid
- Using total profit instead of average annual profit. ARR always requires an annualised figure. Divide total project profit by the number of years before using it in the formula.
- Mixing cash flow with accounting profit. Cash inflows are not accounting profit. You must subtract depreciation (and any other non-cash accounting charges) to get accounting profit before using it in ARR.
- Switching denominator method mid-comparison. Comparing Project A on initial investment against Project B on average investment produces meaningless results. Choose one method and apply it consistently.
- Ignoring salvage value when using average investment. If salvage value is non-zero and you are using the average investment method, include it: (Initial + Salvage) ÷ 2.
- Approving projects on ARR alone. ARR does not capture the time value of money. A project earning large profits only in year 5 looks identical to one earning the same profits in year 1. Always follow a strong ARR result with NPV or IRR analysis.
Frequently asked questions
What is the accounting rate of return formula?
ARR = (Average annual accounting profit ÷ Investment base) × 100. The investment base is either the initial investment (Variant 1) or the average investment calculated as (Initial + Salvage) ÷ 2 (Variant 2). Variant 2 is most common in capital-budgeting practice.
What is the difference between initial investment and average investment in ARR?
Initial investment uses the full upfront cost as the denominator — simpler but more conservative. Average investment uses (Initial + Salvage) ÷ 2, recognising that the book value declines over the asset's life. Average investment produces a higher ARR on the same numbers. The same method must be used consistently when comparing projects.
Should annual profit be before or after depreciation?
After depreciation. ARR uses accounting profit, which includes the depreciation charge. If you only have cash inflows, subtract the annual straight-line depreciation to derive accounting profit.
Is ARR the same as ROI?
Related but not identical. ROI is a general term used in many contexts. ARR is specifically a capital-budgeting metric that uses average annual accounting profit and an investment base — usually average investment. ROI formulas vary widely; ARR is more standardised within its context.
What is a good ARR?
It depends entirely on the company's hurdle rate — typically the weighted average cost of capital (WACC) plus a risk premium. Common hurdle rates range from 10–25% depending on industry and project risk. ARR is most useful when compared against a benchmark, not assessed in isolation.
Does ARR consider the time value of money?
No. ARR treats accounting profit as equal regardless of when it is earned. This is its primary limitation — use NPV or IRR when the timing of cash flows materially affects the decision.